Archive for the 'Coase theorem' Category

Stigler Confirms that Wicksteed Did Indeed Discover the Coase Theorem

The world is full of surprises, a fact with which rational-expectations theorists have not yet come to grips. Yesterday I was surprised to find that a post of mine from May 2016, was attracting lots of traffic. When published, that post had not attracted much attention, and I had more or less forgotten about it, but when I quickly went back to look at it, I recalled that I had thought well of it, because in the process of calling attention to Wicksteed’s anticipation of the Coase Theorem, I thought that I had done a good job of demonstrating one of my favorite talking points: that what we think of as microeconomics (supply-demand analysis aka partial-equilibrium analysis) requires a macrofoundation, namely that all markets but the one under analysis are in equilibrium. In particular, Wicksteed showed that to use cost as a determinant of price in the context of partial-equilibrium analysis, one must assume that the prices of everything else have already been determined, because costs don’t exist independently of the prices of all other outputs. But, unfortunately, the post went pretty much unnoticed. Until yesterday.

After noticing all the traffic that an old post was suddenly receiving, I found that the source was Tyler Cowen’s Marginal Revolution blog, a link to my three-year-old post having been included in a post with five other links. I was curious to see if readers of Tyler’s blog would react to my post, so I checked the comments to his post. Most of them were directed towards the other links that Tyler included, but there were a few that mentioned mine. None of the comments really engaged with my larger point about Wicksteed; most of them focused on my claim that Wicksteed had anticipated the Coase Theorem. Here’s the most pointed comment, by Alan Gunn.

If Wicksteed didn’t mention transaction costs, he didn’t discover the Coase theorem. The importance of transaction costs and the errors economists make when they ignore them are what make Coase’s work important. The stuff about how initial assignment of rights doesn’t matter if transaction costs are zero is obvious and trivial.

A bit later I found that Scott Sumner, whose recent post on Econlib was also linked to by Tyler, added a comment to my post that more gently makes precisely a point exactly opposite of Alan Gunn’s.

Very good post. Some would argue that the essence of the Coase Theorem is not that the initial distribution of property rights doesn’t matter, but rather that it doesn’t matter if there are no transactions costs. I seem to recall that that was Coase’s view.

I agree with Scott that the essential point of the Coase Theorem is that if there are zero transactions costs, the initial allocation doesn’t matter. To credit Wicksteed with anticipating the Coase Theorem, you have to assume that Wicksteed understood that transactions costs had to be zero. But the zero transactions costs assumption was the default assumption. The question is then whether the observation that the final allocation is independent of the initial allocation is a real discovery even if the assumption of zero transactions cost is made only implicitly. Wicksteed obviously did make that assumption, because his result would not have followed if transactions costs were zero. Articulating explicitly an assumption that was assumed implicitly is important, but the substance of the argument is unchanged.

I can’t comment on what Coase’s view of his theorem was, but Stigler clearly did view the Theorem to refer to a situation in which transactions costs were zero. And it was Stigler who attached the name Coase Theorem to Coase’s discovery, and he clearly thought that it was a discovery because the chapter in Stigler’s autobiography Memoirs of an Unregulated Economist in which he recounts the events surrounding the discovery of the Coase Theorem is entitle “Eureka!” (exclamation point is Stigler’s).

The chapter begins as follows:

Scientific discoveries are usually the product of dozens upon dozens tentative explorations, with almost as many blind alleys followed too long. The rare idea that grows into a hypothesis, even more rarely overcomes the difficulties and contradictions it soon encounters. An Archimedes who suddenly has a marvelous idea and shouts “Eureka!” is the hero of the rarest of events. I have spend all of my professional life in the company of first-class scholars but only once have I encountered something like the sudden Archimedian revelation – as an observer. (p. 73)

After recounting the history of the Marshallian doctrine of external economies and its development by Pigou into a deviation between private and social costs, Stigler continues:

The disharmonies between private and social interests produced by external economies and diseconomies became gospel to the economics profession. . . . When, in 1960, Ronald Coase criticized Pigou’s theory rather casually, in the course of a masterly analysis of the Federal Communications Commission’s work, Chicago economists could not understand how so fine an economist as Coase could make so obvious a mistake. Since he persisted [he persisted!], we invited Coase . . . to come and give a talk on it. Some twenty economists from the University of Chicago and Ronald Coase assembled one evening at the home of Aaron Director. Ronald asked us to assume, for a time, a world without transactions costs. That seemed reasonable because economists . . .  are accustomed . . . to deal with simplified . . . “models” and problems. . . .

Ronald asked us to believe . . . [that] whatever the assignment of legal liability for damages, or whatever assignment of legal rights of ownership, the assignments would have no effect upon the way economic resources would be used! We strongly objected to this heresy. Milton Friedman did most of the talking, as usual. He also did much of the thinking, as usual. In the course of two hours of argument the vote went from twenty against and one for Coase to twenty-one for Coase. What an exhilarating event! I lamented afterward that we had not the clairvoyance to tape it (pp. 74-76)

Stigler then summarizes Coase’s argument and proceeds to tell his understanding of the proposition that he called the Coase Theorem.

This proposition, that when there are no transactions costs the assignments of legal rights have no effect upon the allocation of resources among economic enterprises, will, I hope, be reasonable and possibly even obvious once it is explained. Nevertheless there were a fair number of “refutations” published in the economic journals. I christened the proposition the “Coase Theorem” and that is how it is known today. Scientific theories are hardly ever named after their first discoverers . . . so this is a rare example of correct attribution of a priority.

Well, not so much. Coase’s real insight was to see that all economic exchange involves an exchange of rights over resources rather than over the resources themselves. But the insight that the final allocation is independent of the initial allocation was Wicksteed’s.

P. H. Wicksteed, the Coase Theorem, and the Real Cost Fallacy

I am now busy writing a paper with my colleague Paul Zimmerman, documenting a claim that I made just over four years ago that P. H. Wicksteed discovered the Coase Theorem. The paper is due to be presented at the History of Economics Society Conference next month at Duke University. At some point soon after the paper is written, I plan to post it on SSRN.

Briefly, the point of the paper is that Wicksteed’s argument that there is no such thing as a supply curve in the sense that the supply curve of a commodity in fixed supply is just the reverse of a certain section of the demand curve, the section depending on how the given stock of the commodity is initially distributed among market participants. However the initial stock is distributed, the final price and the final allocation of the commodity is determined by the preferences of the market participants reflected in their individual demands for the commodity. But this is exactly the reasoning underlying the Coase Theorem: the initial assignment of liability for damages has no effect on the final allocation of resources if transactions costs are zero (as Wicksteed implicitly assumed in his argument). Coase’s originality was not in his reasoning, but in recognizing that economic exchange is not the mere trading of physical goods but trading rights to property or rights to engage in certain types of conduct affecting property.

But Wicksteed went further than just showing that the initial distribution of a commodity in fixed supply does not affect the equilibrium price of the commodity or its equilibrium distribution. He showed that in a production economy, cost has no effect on equilibrium price or the equilibrium allocation of resources and goods and services, which seems a remarkably sweeping assertion. But I think that Wicksteed was right in that assertion, and I think that, in making that assertion, he anticipated a point that I have made numerous times on this blog (e.g., here) namely, that just as macroeconomic requires microfoundations, microeconomics requires macrofoundations. The whole of standard microeconomics, e.g., assertions about the effects of an excise tax on price and output, presumes the existence of equilibrium in all markets other than the one being subjected to micro-analysis. Without the background assumption of equilibrium, it would be impossible to derive what Paul Samuelson (incorrectly) called “meaningful theorems,” (the mistake stemming from the absurd positivist presumption that empirically testable statements are the only statements that are meaningful).

So let me quote from Wicksteed’s 1914 paper “The Scope and Method of Political Economy in the Light of the Marginal Theory of Value and Distribution.”

[S]o far we have only dealt with the market in the narrower sense. Our investigations throw sufficient light on the distribution of the hay harvest, for instance, or on the “catch” of a fishing fleet. But where the production is continuous, as in mining or in ironworks, will the same theory still suffice to guide us? Here again we encounter the attempt to establish two co-ordinate principles, diagrammatically represented by two intersecting curves; for though the “cost of production” theory of value is generally repudiated, we are still foo often taught to look for the forces that determine the stream of supply along two lines, the value of the product, regulated by the law of the market, and the cost of production. But what is cost of production? In the market of commodities I am ready to give as much as the article is worth to me, and I cannot get it unless I give as much as it is worth to others. In the same way, if I employ land or labour or tools to produce something, I shall be ready to give as much as they are worth to me, and I shall have to give as much as they are worth to others-always, of course, differentially. Their worth to me is determined by their differential effect upon my product, their worth to others by the like effect upon their products . . . Again we have an alias merely. Cost of production is merely the form in which the desiredness a thing possesses for someone else presents itself to me. When we take the collective curve of demand for any factor of production we see again that it is entirely composed of demands, and my adjustment of my own demands to the cond ditions imposed by the demands of others is of exactly the same nature whether I am buying cabbages or factors for the production of steel plates. I have to adjust my desire for a thing to the desires of others for the same thing, not to find some principle other than that of desiredness, co-ordinate with it as a second determinant of market price. The second determinant, here as everywhere, is the supply. It is not until we have perfectly grasped the truth that costs of production of one thing are nothing whatever but an alias of efficiencies in production of other things that we shall be finally emancipated from the ancient fallacy we have so often thrust out at the door, while always leaving the window open for its return.

The upshot of Wicksteed’s argument appears to be that cost, viewed as an independent determinant of price or the allocation of resources, is a redundant concept. Cost as a determinant of value is useful only in the context of a background of general equilibrium in which the prices of all but a single commodity have already been determined. The usual partial-equilibrium apparatus for determining the price of a single commodity in terms of the demand for and the supply of that single product, presumes a given technology for converting inputs into output, and given factor prices, so that the costs can be calculated based on those assumptions. In principle, that exercise is no different from finding the intersection between the demand-price curve and the supply-price curve for a commodity in fixed supply, the demand-price curve and the supply-price curve being conditional on a particular arbitrary assumption about the initial distribution of the commodity among market participants. In the analysis of a production economy, the determination of equilibrium price and output in a single market can proceed in terms of a demand curve for the product and a supply curve (reflecting the aggregate of individual firm marginal-cost curves). However, in this case the supply curve is conditional on the assumption that prices of all other outputs and all factor prices have already been determined. But from the perspective of general equilibrium, the determination of the vector of prices, including all factor prices, that is consistent with general equilibrium cannot be carried out by computing production costs for each individual output, because the factor prices required for a computation of the production costs for any product are unknown until the general equilibrium solution has itself been found.

Thus, the notion that cost can serve as an independent determinant of equilibrium price is an exercise in question begging, because cost is no less an equilibrium concept than price. Cost cannot be logically prior to price if both are determined simultaneously and are mutually interdependent. All that is logically prior to equilibrium price in a basic economic model are the preferences of market participants and the technology for converting inputs into outputs. Cost is not an explanatory variable; it is an explained variable. That is the ultimate fallacy in the doctrine of real costs defended so tenaciously by Jacob Viner in chapter eight of his classic Studies in the Theory of International Trade. That Paul Samuelson in one of his many classic papers, “International Trade and the Equalization of Factor Prices,” could have defended Viner and the real-cost doctrine, failing to realize that costs are simultaneously determined with prices in equilibrium, and are indeterminate outside of equilibrium, seems to me to be a quite remarkable lapse of reasoning on Samuelson’s part.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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